A Stock-Flow Consistent Model of the Shadow Banking System with Some Minsky Dynamics

Description

This paper examines the internal dynamics of an artificial economy by use of the stock-flow consistent (SFC) macroeconomic modelling. Two (2) financial subsectors –commercial banks and investment banks – are incorporated to delineate their interactions. The commercial banks originate mortgages, and issue mortgage-based securities (MBS) whose price is positively correlated with housing prices, while the investment banks purchase the securities. An increase in autonomous consumption by households leads to higher levels of economic activities. The time path shows cyclical dynamics resulting from investment behaviour of the producing firm sector and mortgage management of households. Commercial banks and investment banks react differently. In the new steady state, leverage of commercial banks is higher and leverage of investment banks is lower than the initial baseline levels.
Changes in the interest rate on mortgages influence the time path significantly. A lower interest rate on mortgages increases housing demand, and output goes up. Both housing prices and security prices decrease, which lowers the net worth of investment banks. The leverage of investment banks goes up in the new steady state.
A lower MBS price decreases the net worth of investment banks and increases leverage, which pushes down housing demand, and mortgage demand decreases. Therefore, output and household income decline. Commercial banks’ leverage is higher, while investment banks’ leverage is lower than that in the initial baseline solution. The model demonstrates that investment banks are counter-cyclical with asset management and price changes in MBS. However, financial factors can act as sources of financial fragility.